Independent Contractor or Employee? IRS Guidance for Startups and SMBs

Here’s a strategy you see employed by many startups–hiring “independent contractors” to fill temporary or permanent positions. From an economic standpoint, this may seem wise as a company in startup mode may be testing the viability of its product or service, or be in the process of securing funding and may not have the funds to commit to permanent hiring, which would mean not only paying employees’ salaries, but incurring the cost of the employee benefits it offers. And so, it may seem that the safest economic route for many startups and growing SMBs is to simply hire “independent contractors” in lieu of employees.

But this strategy is not without risk. This is because the IRS has been scrutinizing situations where workers are treated as independent contractors by the employing company, but are “de facto” or "in fact", employees. Proper “worker classification,” as it is often referred to, is a major focus for the IRS. The primary reason the IRS has upped its focus in this area? Payroll taxes!

You see, employers are required to withhold Federal Income Tax, and pay Social Security, Medicare and Federal Unemployment Tax (FUTA) on the wages of their employees. On the other hand, there is generally no withholding or payment of employment taxes required on payments to independent contractors. If the IRS discovers that an employer has improperly classified workers as independent contractors, when they should have been classified as employees, the employer can be held liable for failing to withhold and for all associated employment taxes, plus penalties and interest. Because payroll taxes are considered "trust fund" taxes, the resulting penalties can be onerous! The IRS also has the authority to assess any and all “responsible parties” for the amounts due. This means that a company’s corporate officers  - which the IRS considers “responsible parties” - can be held personally liable.

Given the IRS’ focus in this area, does this mean that a company that legitimately hires independent contractors is at risk for having those workers reclassified as employees?

Certainly businesses the IRS suspects have willfully and knowingly improperly classify workers as independent contractors – when there are strong indications that the workers are in fact employees - are at risk. Businesses in certain industries that the IRS has found to frequently engage in misclassification, such as construction companies, are also likely to be scrutinized.

But what about startups and other growing businesses that have already hired, or plan to hire, independent contractors. Are there certain factors the IRS focuses on that businesses should consider when engaging a worker to help them determine whether they have entered into an employer-employee relationship, or have hired an independent contractor?

Key factors the IRS considers for determining whether a worker is an independent contractor or employee

In general, there are two main factors the IRS considers in determining whether an independent contractor is in fact, an employee. These include:

• The overall business relationship between the worker and the business that engages them.
• The degree of control and independence the worker has.

Additionally, according to the IRS’ guidelines, facts that provide evidence of the degree of control or independence fall into three categories: behavioral control, financial control, and the type of relationship. 

Behavioral control

When determining the level of behavioral control that exists between the business and the worker, the IRS will look at factors that deal with whether the business has a right to direct and control how the worker completes the task or job the worker was hired for. The overall key consideration is whether the business has retained the right to control the details of the worker's performance or instead has given up that right. Factors the IRS looks at include the nature and level of instruction and/or training the business gives to the worker and the level of oversight the business has over the worker. For instance, an employer-employee relationship is more likely to exist where the business dictates and controls the following:

• When and where the worker performs his or her work.
• What tools or equipment the worker should use to perform the work.
• Where to purchase supplies and services.
• What assistants to hire to help perform the work.
• What work must be performed by a specified individual.
• What order or sequence should be followed in performing the work.
• What training the business gives to the worker, especially if the worker is trained to perform their work in a manner chosen by the business.

However, even if no instructions are given, the IRS may still find that sufficient behavioral control exist if the employer has the right to control how the work results are achieved.

Financial control

The factors the IRS looks at when determining the level of financial control that exists between the business and the worker focus on the financial connection or interdependence between the business and the worker. Some of the factors that demonstrate the level of financial control include:

• The extent to which the worker has unreimbursed business expenses. Since independent contractors are more likely to have unreimbursed expenses than are employees, having expenses reimbursed on a frequent basis are more likely to show an employer-employee relationship. Also important is whether the worker has fixed ongoing costs that are incurred regardless of whether work is currently being performed. These would be more likely to be incurred by an independent contractor.
• The extent of the worker's investment is also important since an independent contractor often has a significant investment in the facilities or tools used to perform their services. However, the IRS guidelines say that this would not be the sole determining factor since a significant investment isn’t always necessary for independent contractor status.
• The extent to which the worker makes his or her services available to the relevant market since an independent contractor is generally free to seek out other business opportunities. Independent contractors also often advertise, maintain a visible business location, and/or are available to work for or provide their services to other businesses in the relevant market.
• How the business pays the worker is another factor, since an employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. An independent contractor, however, is more likely to be paid a fixed fee or on a time and materials basis, although in some professions, such as law, it is common to pay independent contractors on an hourly basis.

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Type of relationship

Here the focus is on the contracts, actions or understanding that exists between the business and the worker. Some of the factors that impact the type of relationship include:

• Whether there are written contracts describing the relationship the parties have created or entered into, and what the contract describes.
• Whether the business provides the worker with employee-type benefits, such as health insurance, a pension plan, vacation or sick pay.
• How “permanent” the relationship is intended to be. For instance, when a worker is hired for an indefinite period, rather than for a specific project or finite period, it is more likely that the relationship is that of an employer-employee.
• The extent to which services performed by the worker are a key aspect of the company's regular business since an “independent contractor” that has been engaged to perform services that are a key aspect of business' activity is less likely to be able to direct and control their work activities. An example in an IRS publication for this factor includes a law firm that hires an “independent contractor” attorney. Since it is likely that the law firm will present the attorney's work as its own and have the right to control or direct that work, the IRS would say this indicates an employer-employee relationship.

Asking the IRS to make a determination

Even after considering all of the factors and how they apply to their particular situation, a business may still be uncertain as to whether a worker should be classified as an employee or independent contractor. Because the consequences of misclassifying workers can be severe, a business may want to consider requesting a determination from the IRS. This is done by filing IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (PDF). The IRS will consider the facts and circumstances detailed in the form and make a subjective determination. For this reason, this form should be carefully prepared, include all relevant information, but not be misleading. Note that Form SS-8 can also be filed by a worker who believes a business has not classified them correctly.

Conclusion

While many businesses, including start-ups and other SMBs, believe that the most cost effective approach to staffing a position is to hire an independent contractor, businesses should keep in mind that worker classification is an area the IRS is highly scrutinizing. When a worker who is in effect an employee, is improperly classified as independent contractor, payroll taxes are not withheld and employment taxes are not paid, the consequences of which can be crippling.  And although I've only addressed the IRS' view and federal payroll tax issues, the consequences can also include penalties and sanctions imposed by taxing and labor agencies, such as the state Departments of Revenue and the state agencies that administer state unemployment and workers compensation insurance.

Still, this does not mean that a business who legitimately hires an independent contractor should automatically reclassify them as an employee or that a business should be hesitant to hire independent contractors. There are many factors a business can consider to help make a proper determination. Of course, obtaining the assistance of a qualified CPA or attorney is always wise - especially if this is a significant issue for the business. Finally, in addition to the guidance above, the IRS also has many additional resources on its website, including the following:

• IRS Internal Training: Employee/Independent Contractor (PDF)
• Publication 15-A, Employer’s Supplemental Tax Guide, (PDF) (Discussion on independent contractor vs. employee begins at page 7)

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